Must-know: Why a Charter bid for Time Warner Cable is possible

While news broke on Friday, November 22, 2013 that Comcast (CMCSA) may pursue an acquisition of Time Warner Cable (TWC), rival cable provider Charter Communications (CHTR) has been known to be pursuing Time Warner for several months. The news of a possible competing bid led to a 10% spike in TWC shares to a new 52-week high of $132.92. All three companies belong to the iShares U.S. Consumer Services ETF (IYC), which tracks the performance of the Dow Jones U.S. Consumer Services Index.

On March 19, 2013, Charter announced that it had entered into an agreement to sell a 27% stake in the company to John Malone’s Liberty Media Corp. (LMCA), a mostly foreign-based cable, media, and communications company. Malone, who exited the domestic cable industry in 1999 with the sale of TCI, has re-entered the U.S. market and has been upfront about his plans to consolidate the industry. As part of the agreement of Charter, Malone has the right to appoint four directors to the board, including Gregory Maffei, CEO of Liberty Media. When speaking about potential consolidation, Maffei expressed the view that, “Consolidation is helpful, Time Warner Cable is appealing.” Statements such as these have helped to elevate TWC stock despite the company’s struggling operations.

Is a Charter bid realistic?

As opposed to a purchase by Comcast, which has roughly double the amount of subscribers as Time Warner, Charter is a significantly smaller company with only about 4.2 million video subscriber compared to Time Warner’s 11.4 million. Time Warner’s market capitalization is approximately 2.5 times that of Charter’s $14 billion. However, a purchase of Time Warner Cable would likely top $62 billion. To fund such as takeover, Charter would likely have to take on substantial additional debt in order to pay TWC shareholders in cash.

Given the spike in TWC shares resulting from buyout speculation, investors should pay careful attention to the likelihood of success of a potential merger. In this case, investors must assess Charter’s additional debt capacity to determine if the company can complete the purchase. One way to do this is to examine Charter’s leverage, or the amount of debt outstanding compared to the level of profits defined by earnings before interest, taxes, depreciation, and amortization (EBITDA). The higher the leverage, the less additional debt a company can take on. Charter’s leverage is one of the highest in the industry and has been increasing rapidly. This greatly diminishes the company’s ability to take on additional debt to fund a purchase of Time Warner Cable. So, similar to a Comcast bid that’s likely to face regulatory hurdles, a Charter bid may be equally troubled, meaning the run-up in TWC shares may prove short-lived.